How to Profit From Real Estate

How to Profit From Real Estate

Updated Jun 25, 2019

What Is Real Estate?

Real estate is property made up of land and the buildings on it, as well as the natural resources of the land, including uncultivated flora and fauna, farmed crops and livestock, water and mineral deposits.

Although the media often refers to the "real estate market," real estate can be grouped into three broad categories based on its use.

Residential real estate includes undeveloped land, houses, condominiums, and townhouses. The structures may be single-family or multi-family dwellings and may be owner occupied or rental properties.

Commercial real estate includes nonresidential structures such as office buildings, warehouses, and retail buildings. These buildings may be free standing or in shopping malls.

Industrial real estate includes factories, business parks, mines, and farms. These properties are usually larger in size and locations may include access to transportation hubs such as rail lines and harbors.

The Basics of Real Estate

Real estate is a tangible asset and a type of real property. Real property includes land, buildings and other improvements, plus the rights of use and enjoyment of that land and all its improvements. Renters and leaseholders may have rights to inhabit land or buildings that are considered a part of their estate, but these rights themselves are not, strictly speaking, considered real estate.

Real property is not the same thing and should not to be confused with personal property. Personal property includes intangible assets like investments, along with tangible assets such as furniture and fixtures like a dishwasher. Also, even renters may claim parts of a home as personal property, provided you bought and installed the property with the lessor's permission.

KEY TAKEAWAYS

Real estate is real—that is, tangible—property made up of land as well as anything on it, including buildings, flora and fauna, and natural resources.

Real estate has three basic categories: residential, commercial and industrial.

When it comes to investing, residential real estate is less expensive and more feasible to individuals, while commercial real estate is more valuable and more stable.

As an investment, real estate offers income and capital appreciation.

You can invest in real estate directly—buying land or property—or indirectly through buying shares in publicly traded real estate investment trusts (REITs) or mortgage-backed securities (MBS).

Residential Real Estate and Home Ownership

In the 2019 edition of its annual home-value analysis, the real estate website Zillow estimated the total value of all U.S. homes in 2018 was $33.3 trillion, 71% higher than the nation's gross domestic product (GDP) of $19.4 trillion at the time. Homeownership, also known as owner-occupancy, is the most common type of real estate investment in the United States. According to the National Multifamily Housing Council (NMHC), roughly two-thirds of residents own their home. Often, these owners have financed the purchase by taking out a mortgage loan, in which the property acts as collateral for the debt.

Individuals shopping for home mortgages to help them realize the dream of property ownership are faced with a variety of options. Mortgages can charge either fixed-rate or variable-rate interest. Fixed-rate mortgages generally have higher interest rates than variable-rate mortgages, which can make them more expensive in the short run. Fixed-rate loans cost more in the short term because they are protected from future interest rate increases.

Banks publish amortization schedules that show how much of a borrower's monthly payments go to paying off interest versus how much goes to paying off the principal of the loan. Balloon loans are mortgages that don't fully amortize—reduce to zero—over time. Instead, the borrower pays interest for a set period, five years for example, and then must pay the remainder of the loan in a balloon payment at the end of the term.

Also, mortgages can come with heavy costs that include transaction fees and taxes. These additional expenses are often rolled into the loan. Once potential homeowners have proven their eligibility and secured a mortgage from a bank or other lender, they must complete additional steps to make sure the property is legally for sale and in good condition.

Commercial Real Estate

Commercial real estate is used for commerce and includes anything from strip malls and free-standing restaurants to office buildings and skyscrapers. It is often distinguished from industrial real estate, which is practical space used in the manufacturing of products.

Buying or leasing real estate for commercial purposes is very different from buying a home or even buying residential real estate. Commercial leases are generally longer than residential leases. Commercial real estate returns are based on their profitability per square foot, unlike structures intended to be private residences. Moreover, lenders may require a larger down payment on a mortgage for commercial real estate then what is required for a residence.

Investing in Real Estate

Unlike other investments, real estate is dramatically affected by its surroundings and immediate geographic area. Hence the well-known real-estate maxim "location, location, location." Except for a severe national recession or depression, residential real estate values, in particular, are affected primarily by local factors. Such factors include the area's employment rate, the local economy, crime rates, transportation facilities, quality of schools, municipal services, and property taxes.

Pros

Offers steady income

Offers capital appreciation

Diversifies portfolio

Can be bought with leverage

Cons

Is usually illiquid

Influenced by highly local factors

Requires big initial capital outlay

May require active management, expertise

There are key differences in residential and commercial real estate investments. On the one hand, residential real estate is usually less expensive and smaller than commercial real estate, and so it is more affordable for the small investor.

On the other hand, commercial real estate is often more valuable per square foot, and its leases are longer, which theoretically ensures a more predictable income stream. With greater revenue comes greater responsibility. Commercial rental real estate is more heavily regulated than residential real estate, and these regulations can differ not only from country to country and state by state but also by county and city. Even within cities, zoning regulations add a layer of unwanted complexity to commercial real estate investments.

There is also increased risk of tenant turnover in commercial rental agreements. If the lessee's business model is bad, their product is unattractive, or they are poor managers, they might declare bankruptcy. The business failure can abruptly stop expensive real estate from generating revenue.

Moreover, just as property can appreciate, it can also depreciate. Once-hot retail locations have been known to decay into rotten shopping centers and dead malls.

How to Profit From Real Estate

One can invest in real estate directly by buying actual properties or parcels of land; or indirectly, by buying shares in publicly traded real estate investment trusts (REITs) or mortgage-backed securities (MBS). The indirect investment methods may offer less return and less control, but they are vastly more liquid than owning physical real estate and don't require in-depth knowledge of the real estate business.

Investing directly in real estate results in profits—or losses—through two avenues, which haven't changed in centuries:

Revenue from rent or leases

Appreciation of the real estate's value

Appreciation

Appreciation is achieved through different means, but the increase in a property’s value isn't realized until the owner sells it the property. Another way to realize profit would be to refinance the mortgage. Raw and undeveloped land, like the territory right outside a city’s borders, offers the biggest potential for construction, enhancement, and profit. Appreciation can also come from discovering valuable materials or natural resources on a plot of land, like striking oil. Also, a rise in the market values of the area around the land you own.

As a neighborhood grows and develops, property values tend to climb. The gentrification of urban neighborhoods in some American cities over the last few decades has often resulted in a dramatic increase in real estate prices. Scarcity can also play a role in the value of real estate holdings. If a lot is the last of its size or kind in a prestigious area—or one where such lots rarely become available—it gains in marketability.

Income

Income from real estate comes in many forms. The biggest generator is the rent paid on land already developed into residential or commercial properties. However, companies will also pay royalties for natural resource discoveries on raw land. Also, they may pay to build structures on it, like cell towers or pipelines.

Income can also come from indirect real estate investments. In a REIT, the owner of multiple properties sells shares to investors and passes along rental income in the form of distributions. Similarly, in an MBS, the interest and principal payments from a pool of mortgages are collected and passed through to investors.

Both REITs and MBS investment products trade like stocks, with real estate acting as their underlying security. So, they may offer capital appreciation is the shares gain in market value.

Real World Examples of Real Estate Investments

Mortgage-backed securities got a lot of bad press from the role they played in the mortgage meltdown that triggered a global financial crisis in 2007. However, they are still in existence and traded. The most accessible way for the average investor to buy into these products is via exchange-traded funds(ETFs). Like all investments, these products do carry a degree of risk. However, they may also offer portfolio diversification. Investors must investigate the holdings to ensure the funds specialize in investment-grade MBS, not the subprime variety that figured in the crisis.

As of April 2019, the top-performing vehicles of this type include:

Vanguard Mortgage-Backed Securities ETF (VMBS), which tracks the Bloomberg Barclays U.S. Mortgage-Backed Securities Float Adjusted Index, made up of federal agency-backed MBS that have minimum pools of $250 million and minimum maturity of one year. Priced around $52 per share the fund has a dividend yield of 3.44%.

iShares Barclays MBS Bond ETF (MBB), which focuses on both fixed-rate and adjustable rate mortgage securities, and tracks the Bloomberg Barclays U.S. MBS Index. Its holdings include bonds issued or guaranteed by government-sponsored enterprises like Fannie Mae and Freddie Mac, so they are AAA-rated. Trading around $105 per share, it offers a yield of 3.02%.

SPDR Bloomberg Barclays Capital Mortgage Backed Bond ETF (MBG), which also uses the Barclays U.S. MBS Index as a benchmark, but adopts a more aggressive approach to boost returns. Price at $25 per share, it offers a yield of 3.38%.

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